Question

(PLEASE SHOW WORK)

Hankins Corporation has 5.4 million shares of common stock outstanding; 290,000 shares of 5.2 percent preferred stock outstanding, par value of $100; and 125,000 5.7 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $72 per share and has a beta of 1.13, the preferred stock currently sells for $103 per share, and the bonds have 20 years to maturity and sell for 103 percent of par. The market risk premium is 6.8 percent, T-bills are yielding 4.3 percent, and the firm’s tax rate is 23 percent.

1. What is the firm’s market value capital structure?

2. If the firm is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?

Answer 1

1

MV of equity=Price of equity*number of shares outstanding

MV of equity=72*5400000

=388800000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*125000*1.03

=128750000

MV of Preferred equity=Price*number of shares outstanding

MV of Preferred equity=103*290000

=29870000

MV of firm = MV of Equity + MV of Bond+ MV of Preferred equity

=388800000+128750000+29870000

=547420000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 388800000/547420000

W(E)=0.7102

Weight of debt = MV of Bond/MV of firm

Weight of debt = 128750000/547420000

W(D)=0.2352

Weight of preferred equity = MV of preferred equity/MV of firm

Weight of preferred equity = 29870000/547420000

W(PE)=0.0546

2

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 4.3 + 1.13 * (6.8)

Cost of equity% = 11.98

Cost of debt

K = Nx2

Bond Price =∑ [(Semi Annual Coupon)/(1 + YTM/2)^k]     +   Par value/(1 + YTM/2)^Nx2

k=1

K =20x2

1030 =∑ [(5.7*1000/200)/(1 + YTM/200)^k]     +   1000/(1 + YTM/200)^20x2

k=1

YTM = 5.4518008284

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 5.4518008284*(1-0.23)

= 4.197886637868

cost of preferred equity

cost of preferred equity = Preferred dividend/price*100

cost of preferred equity = 5.2/(103)*100

=5.05

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.2*0.2352+11.98*0.7102+5.05*0.0546

WACC =9.77%